What Are We Measuring with ESG?
ESG (environmental, social and governance) is a new regulatory development, and regulatory bodies are increasingly active in setting standards and requirements for the stakeholders to follow.
As government and industry demand for ESG increases, investors’ and company leaderships’ need for information also rises. However, organizations are challenged with tracking regulatory guidance and data gathering. It also creates learning opportunities for regulators seeking greater clarity around the objectives and compliance with the regulations.
The issues are broad and complex; as such, it is difficult to say what’s next for ESG regulations because there are many gray areas to define. There are still many questions about how and what to measure, as well as how that information is weighed and rated.
- What type of sustainability information serves ESG investors?
- How do investors reconcile ESG costs with revenue growth?
- How do you measure sociological impact?
- To what extent can a company be defined as ESG-compliant or ESG leader when it tracks well on one of the components (like environmental, for example) but not so well on the other two?
While the scope of ESG remains open to interpretation, depending on the objectives of the various stakeholders, here is what we know about it today.
Regulators and Policymakers are Doubling Efforts on ESG
The Financial Stability Oversight Council (FSOC) identified in its 2021 report that climate change is an emerging and increasing threat to US financial stability. The spike in climate-related disaster events is costing the US hundreds of billions of dollars annually. Adding to that is the cost of shifting policy, consumer and business sentiment, or technologies associated with the changes necessary to limit climate change.
Unsurprisingly, according to PRI, there are now 868 policies and regulatory guidance as well as more than 300 policy revisions that support, encourage, or require investors to consider all long-term value drivers, including ESG factors.
Sustainable finance policies and regulations aim to:
- Support national policy goals on climate change and the SDGs;
- Enhance the resilience and stability of the financial system and the economy;
- Improve market efficiency by clarifying and aligning investor and company expectations;
- Increase the attractiveness of countries as investment destinations.
In March 2022, The Securities and Exchange Commission (SEC) proposed the climate disclosure rule proposal that opens the door for the broadest federally mandated corporate ESG data disclosure requirement in the US.
While resembling trends in other global regions, this proposal includes scope for disclosures to accelerate in the US and potentially narrow gaps with some of APAC’s leading jurisdictions on ESG disclosures (Australia, ASEAN, and HK).
The rule proposal would require all domestic or foreign registrants to include certain climate-related information, such as:
- Climate-related risks and their actual or likely material impacts on the registrant’s business, strategy, and outlook;
- The registrant’s governance of climate-related risks and relevant risk management processes;
- The registrant’s greenhouse gas (“GHG”) emissions, which, for accelerated and large accelerated filers and with respect to certain emissions, would be subject to assurance;
- Certain climate-related financial statement metrics and related disclosures in a note to its audited financial statements; and
- Information about climate-related targets and goals, and transition plan, if any.
Legal challenges are expected, and additional corporate disclosure requirements around human capital, political spending, and increased process disclosures for funds to label as sustainable or ESG are short-term areas of focus for the SEC.
Key Dynamics Shaping the Emerging ESG Regulatory Guidance
Financial v. Social Dichotomy
According to the annual EY 2022 report, ESG is the fastest-growing segment of the asset management industry, with assets in ESG funds growing 53% year-on-year.
ESG intends to serve two primary investor groups:
- Those focused on financial risk (the financial impact of sustainability-related factors on a company).
- Those focused on social impact (the company’s impact on people, communities, the environment, and society).
While financial risk is more tangible and measurable, social impact – such as human rights, labor standards, and other sociological factors – is much harder to quantify against an agreed benchmark due to different social and political factors in various jurisdictions. To complicate matters further, jurisdictions are moving at different speeds in regulating ESG information.
Constantly Shifting Goal Posts
ESG is clearly important to investors and is coming of age, but perceptions about ESG continue to shift as the priorities of policymakers and investors evolve.
Whether it’s “greenwashing” (false reporting on sustainability efforts) or new economic and geopolitical challenges (post-covid inflation spike, the war in Ukraine, growing tensions between the US and China), one thing is clear – ESG efforts need to be flexible to the external environment.
The concept of “dynamic materiality” plays a huge role here. What is considered immaterial or insubstantial today can become critical tomorrow. For example, the manufacturing and distribution of goods made of certain materials or sourced in certain locations can one day become prohibited.
This is why, in the coming years, companies must take on forward‑looking and proactive approaches to materiality and monitor legislative developments in their industry sector.
Varying ESG Rating Methodologies
ESG rating providers have become influential. A total of 3,038 investors representing over $100 trillion in combined assets have signed a commitment to integrate ESG information into their investment decisions. However, the current methodology in weighing E vs. S vs. G criteria varies between rating providers and may not reflect the understanding or interests of investors.
One reason for these disparities is the inability to measure sustainability information comparably across ESG themes. Stakeholders need to be aware of the E, S and G distinctions, measurement limitations, and variations; meanwhile, more work needs to be done on quantifying or reaching an agreement on how to weigh each of the individual attributes.
Though ESG disclosure and reporting are not mandatory and market-led for now, the change will come in fast, and your organization better be ready.
- PRI recommends distinguishing between policymakers and regulators. Broadly, policymakers set the plan which governments pursue. Regulators deliver a mandate set by policymakers. Structure varies by country and, in some countries, these functions overlap. The compliance function needs to pay particular attention to how they interpret their mandate concerning ESG issues and build capacity (people and skills) for monitoring responsible investment implementation.
- As demand for assurance increases, EY recommends that ecosystem actors must recognize the importance of the “three lines of defense” that are critical for building trust and maintaining a rigorous, accurate and unbiased reporting system. The three lines of defense are:
- Business itself: the first responsibility lies with the employees, tracking and following relevant laws and current legislation, and ensuring all operations run in a compliant fashion.
- Compliance function: the second line of defense is guidance and oversight by the compliance team, updating the law library (or lists of legal requirements) with its associated risks and controls, changing business policies, and performing periodic checks and audits.
- The auditors: the third line of defense are the external and internal auditors who independently check all compliance risks and controls in order to report findings to the Board.
- Deloitte highlights that a lot of focus is often on the “E” or “S” elements of ESG, but organizations that put in place strong governance and controls may be better positioned to deliver on their goals and comply with reporting and regulatory requirements. A governance and compliance framework should support effective decision-making and track against corporate and regulatory obligations. Without strong governance, it is difficult to manage noncompliance risks, leading to reputational, regulatory, and financial risks.
If you require better tracking of the upcoming legislation and regulatory updates, Regology offers a Regulatory Change Management solution that helps mitigate risk exposure due to incomplete regulatory coverage.